Fourth Quarter 2023 Investment Commentary
What a difference a year makes. In 2022, high inflation and the Fed’s commitment to tame it led to sharply rising interest rates and negative returns for virtually all traditional asset classes. In 2023, much to the surprise of many forecasters, global stock and bond markets ignored widespread expectations that we were headed for a recession and were able to shake off a host of uncertainties to post strong gains for the year.
Aided by a powerful year-end rally, U.S. stocks jumped nearly 12% in the fourth quarter to finish up 26% for the year and end close to an all-time high. Smaller-cap stocks, which lagged their larger counterparts for most of the year, also rallied sharply in the fourth quarter (+14%) to end the year up 17%.
In an encouraging sign, during the year-end rally, we saw a shift in market leadership and equity gains broaden out beyond the “magnificent 7” stocks (Apple, Microsoft, Nvidia, Facebook, Alphabet, Netflix, Amazon), which had been responsible for much of the U.S. equity markets returns prior to the fourth quarter.
Developed International and emerging-market stocks also posted solid gains but didn’t keep pace with U.S. markets. Developed International stocks gained 18%, while emerging-market stocks posted a nearly 10% return.
Bonds also rallied sharply in the fourth quarter, aided by a significant drop in Treasury yields. The benchmark 10-year Treasury yield declined over 100bps in the fourth quarter, resulting in a 6.8% return for the Bloomberg U.S. Aggregate Bond Index. Interestingly, despite massive intra-year volatility, the 10-year Treasury yield ended the year exactly where it started. For the year, U.S. core bonds finished up 5.5%. Credit was a standout performer both in fourth quarter and for the full year. High-yield bonds were up 7% in the quarter, finishing up 13.4% for the year.
The sharp fourth-quarter rally was driven in large part by Fed policy and falling inflation. The Fed made it clear they believe the end of the war on inflation is near, and not only are they preparing to take their foot off the brake in terms of future rate hikes, but they anticipate interest-rate cuts in 2024.
Portfolio Performance and Key Performance Drivers
For 2023, our active model portfolios were mixed across the range of risk profiles. Positive contributors included allocations to non-core bond funds—Artisan High Income and Vanguard Emerging Market Bond —gained 15.3% and 13.8%, respectively. Active domestic equity manager’s performance fared well overall, highlighted by Harbor Capital Appreciation returning over 50% last year. Overall, relative underperformance occurred among our international managers.
Year-end allocation changes were recommended and approved for an increase in weighting for small-cap equity. The Strategy Committee also approved an allocation to private credit for several balanced portfolios.
Macroeconomic and Investment Outlook
Looking ahead to 2024, all eyes will be on the Fed. When will the Fed start to cut, by how much, and why? With Fed policy top of mind, a key question will be whether the Fed cuts rates because of restrictive policy in the form of high real yields (lower inflation and unchanged Fed Funds) or because economic growth slows more than anticipated. While this question will be in focus, monetary policy is just one of many factors that will influence markets. Geopolitical risk, the U.S. presidential election, labor markets, and inflation will likely fill the headlines and all could be sources of volatility.
In our opinion, a recession is unlikely in the first half of 2024. There are several positives supporting our view including solid economic growth, resilient corporate earnings, declining inflation, and ample liquidity. We think the biggest recession risk will come from weakness among consumers in the latter half of the year and we will continue to closely monitor economic data and adjust our views accordingly.
Inflation
As we stated in our third-quarter commentary, we thought the Fed had the upper hand on inflation and that we would see inflation continue to trend lower. That has been playing out and we continue to believe that inflation will grind lower in the near term. Many of the metrics we observe suggest that inflation is already at or below the Fed’s target. We also continue to monitor the lag effect of monetary policy, i.e., rate hikes take time to flow through the system.
The chart below illustrates the year-over-year inflation and year-over-year inflation excluding shelter costs, which is a key CPI input. (It makes up about 30% of the CPI.) While year-over-year inflation recently came in at 3.1%, this number drops to 1.4% when excluding shelter. These levels are not far from or are below the Fed’s goals, which suggests that the Fed’s policy has been working, and with time inflation could continue to fall, particularly if shelter continues to decline.
Source: U.S. Bureau of Labor Statistics. Data as of 11/1/2023.
We continue to believe that near-term inflation is under control. We would not be surprised to see inflation temporarily fall below the Fed’s 2% target, although we would not expect it to stay there. Importantly, we know that historically, inflation tends to come in waves, so we continue to closely monitor trends in inflation, anticipating a subsequent rise at some point. Of course, factors including the Federal Reserve’s decisions and the government’s use of fiscal policy will play a role in the outlook for inflation.
Another part of the story is liquidity, specifically bank reserves. This is an important point of difference when it comes to this cycle compared to prior cycles when yield curves inverted and Real Fed Funds rates proved too tight. Prior to 2008, the Fed did not pay interest on these reserve accounts. Therefore, banks typically only held what was required to collateralize their deposit base. When banks wanted to expand lending, they were forced to borrow reserves from other banks, which increased short-term interest rates and often helped to tip the economy into recession. However, following the financial crisis in 2008, the Fed has been paying interest on reserves held by banks, which not surprisingly has resulted in historically high levels of bank reserves. The difference today versus the past is that the Fed is not significantly restricting the reserve supply to boost interest rates. The ample supply of reserves suggests that banks can collateralize new lending and that there is significant liquidity in the system during this tightening cycle.
Source: Federal Reserve. Data as of 12/31/2023.
The Road Ahead
Transitions from one economic cycle to the next can be challenging. For example, economic data can present mixed signals, while the timing and magnitude of economic policy and how it flows through to the economy can create uncertainty that leads to volatility. Furthermore, while there are often similarities from cycle to cycle, there are unique aspects to each. Bank reserves, as mentioned above, are one example. Another characteristic of this cycle, which we mentioned in our prior commentary, is the concept of the rolling recession. The business cycle since the onset of the pandemic has been anything but ordinary. Instead of a simultaneous and broad-based decline in economic activity, we’ve observed industries face isolated declines over time, while the broad economy has managed to stay afloat.
Throughout 2020, Covid had an unprecedented impact on societies around the world. Many non-essential service-oriented businesses, such as air travel and tourism, experienced a depression-like scenario as demand evaporated. Conversely, goods-related businesses experienced a boom. Officially, there was an NBER-defined recession in 2020 that lasted from February 2020 to April 2020. Then through 2021 and 2022, consumer habits flipped and demand for services surged as economies around the world re-opened. As inflation took hold and interest rate increases became inevitable, rate-sensitive areas of the economy contracted. The housing market froze and a higher cost of capital for technology firms caused funding to dry up and there were layoffs across the sector. In 2023, we have seen regional banks and commercial real estate face declines.
With various sectors of the economy experiencing contractions at different times over the last few years, we would anticipate more of a mild slowdown, not a deep economic downturn. But of course, we will be closely monitoring corporate earnings, labor statistics, and financial conditions to best assess the ultimate type of “landing.” There is growing consensus that a “soft landing” may occur in the U.S. in 2024, and we are not ruling that out, especially if the Fed cuts rates sooner than later.
Equity Markets
In November, the Fed made it clear they believe the end of the war on inflation is near, and not only are they preparing to take their foot off the brake, but they are also anticipating interest-rate cuts in 2024. At the same time, the Fed also said it foresees the economy remaining relatively healthy with steady growth and modest levels of unemployment. Historically, the end of the Fed’s hiking cycle usually serves as a tailwind for stocks.
Within the U.S. market, performance in 2023 was driven by the handful of mega-cap growth stocks (dubbed the “Magnificent Seven”), and the concentration in these names at the top of the index remains at historic levels. These stocks had an average return in excess of 100% for 2023 and now represent a combined weight of more than 28% in the S&P 500 and 47% in the Russell 1000 Growth Index.
With the market confident that interest rates have reached their cyclical peak, we also saw a shift in market leadership with equity gains broadening out beyond the “magnificent seven.” As seen in the chart above, the remaining 493 stocks in the index rallied 15% to end the year. We believe the recent broadening out of equity performance has the potential to persist over the course of 2024, and we could see areas of the market that have significantly lagged perform much better. For example, small-cap stocks beat large-cap stocks and value stocks outperformed growth stocks late in the year. We anticipate rebalancing portfolios away from the big winners of 2023 and towards higher-quality, more attractively valued strategies that could perform well in periods of heightened volatility.
Earnings in the U.S. have largely recovered from their lull in 2022. Low double-digit earnings growth is the current consensus expectation for the S&P 500 in 2024. While emerging markets have the highest earnings growth expectations for 2024 at over 17%, earnings have yet to recover following their contraction in 2022—and remain about 16% below their peak level (in local currency terms). The main culprit for the suppressed earnings picture is China. A strong earnings recovery was expected following the removal of their zero-COVID policy in late 2022. But after an initial bounce in early 2023, earnings in China have not moved meaningfully higher. While the Chinese economy has stabilized in the second half of 2023, it has not recovered as many had expected. The COVID reopening playbook that worked for investors in the U.S. and Europe did not provide the proper roadmap for Chinese equities.
Fixed-Income
Looking to 2024, inflation and Fed policy will continue to be major drivers of bond market returns. The question now is how to position for the peak in interest rates. We know that forecasting the timing and magnitude of rate cuts is difficult, and relying on accurate projections for the purposes of asset allocation can be unreliable. If we rewind the clock two years to the end of 2021, rates were 0% and the market forecasted three 0.25% hikes. Instead, there were effectively 17 quarter-point hikes. The market got it wrong again in 2022 when two or three 25bps hikes were expected to be followed by two rate cuts. There were four hikes and no cuts. Now the market is anticipating a handful of cuts in 2024, which could help to avoid a recession and guide the economy in for a soft landing.
We don’t know exactly when or by how much the Fed will cut, but we think the Fed has done its job. Most of what the Fed can control through higher rates has happened: short-term rates have increased, real rates have increased, lending has slowed meaningfully, mortgage rates have jumped, causing the housing market to stall, and commodities have declined. Meanwhile, money supply continues to decrease, and the Fed continues to reduce its balance sheet. As we have mentioned, there are still questions about the lag effects of monetary policy and if there are still negative impacts to be felt.
For now, investors can continue to benefit from today’s higher short-term yields and an inverted yield curve. We also continue to maintain exposure to the longer end of the curve with core bonds. The Bloomberg U.S. Aggregate Bond Index is currently yielding 4.5%, which is above the current 3.1% inflation level. So, bonds finally provide a positive real (after-inflation) yield. We also continue to hold core bonds as a ballast to balanced portfolios, as we believe they will likely provide some downside protection in the event of a recession or market decline due to an exogenous event.
In addition to core bonds, we continue to have meaningful exposure to higher-yielding, actively managed, flexible bond funds run by experienced teams with broad opportunity sets. There are several fixed-income sectors outside of the traditional parts of the bond market that provide attractive risk-return potential, and we access them through active managers. Some of these funds are currently yielding in the high single digits, while maintaining an eye on capital preservation.
Alternatives
Finally, we recommend core positions (5% in a typical balanced portfolio) in private credit. Private credit is a form of lending outside of the traditional banking system, in which lenders work directly with borrowers to negotiate and originate privately held loans that are not traded in public markets. Private credit has historically offered compelling performance in relation to other segments of the fixed-income market. Since the global financial crisis, when private credit began growing in earnest, direct lending (the most common type of private credit) has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.
From a credit-rating perspective, private credit is generally considered comparable to non-investment grade syndicated leveraged loans and high-yield bonds, but there are several differences. Syndicated leveraged loans and high-yield bonds are usually rated by credit rating agencies, which is helpful for assessing default risk and can be traded on secondary markets. Private loans do not tend to be rated, so credit default risk can be harder to evaluate and there may not be an active secondary market, which makes the securities much less liquid. These factors can make private debt riskier so that it is priced at a premium to traditional fixed-income investments, offering the potential for higher yields and returns for investors.
In Closing
We think it is quite possible that 2024 will be a year where investors again enjoy some of the classic underpinnings of investing, where stocks and bonds are less correlated and provide diversification benefits to portfolios. This was not the case in 2022 and 2023 when stocks and bonds both declined meaningfully and then posted gains. Less correlation would be welcomed, as we anticipate an overall choppy market environment given headline risks related to the economy, Fed policy, geopolitical events, and the presidential election (election years have historically been more volatile for the equity markets).
While there are likely to be bouts of volatility, these inevitably create opportunities. Currently, we see opportunities within the stock market, particularly as we expect a broadening out into areas of the market that have lagged. We also think this could be a favorable environment for bottom-up investors in that fundamentals may matter more in an uncertain environment, and picking your spots may be more important than simply buying broad index exposure to the market. Within fixed income, we believe that rates have peaked, inflation is under control for now, and that interest rates will decline though not back to zero. In this environment, we continue to take advantage of the inverted yield curve, capturing higher yields from shorter-term securities while also benefiting from more attractive yields across the bond market. We will also look for any opportunities that arise as a result of the Fed not meeting market expectations around the timing and magnitude of rate cuts.
As we enter 2024, we extend our gratitude for your continued trust and confidence. We wish you and your loved ones peace, happiness, and good health in the new year.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial Group with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved.
